Using Intercompany Transfer Price Analyses in Bankruptcy Valuations Part II
Allowable Intangible Asset Transfer Pricing Methods
The §482 regulations list five categories of intangible assets that are subject to the allowable transfer pricing methods:
- patents, inventions, formulas, processes, designs, patterns or know-how
- copyrights and literary, musical or artistic compositions
- trademarks, trade names or brand names
- franchises, licenses or contracts and
- methods, programs, systems, procedures, campaigns, surveys, forecasts, estimates, customer lists or technical data.
Regulation 1.482-4(b)(1) also provides that "other similar property" is encompassed within the definition of an intangible asset. An intangible asset is considered similar to these specific assets if it derives value from its intellectual content or other intangible qualities, not from its physical attributes.
The arm's-length price for a transfer of intangible assets may be determined using four allowable methods:
- the CUT method
- the CPM
- the profit split method or
- unspecific methods.
1. Comparable Uncontrolled Transaction Method. Companies may rely on CUTs to establish an arm's-length price for the transfer of intangible assets. Under the CUT method, the arm's-length price for a related party transfer of intangible assets is equal to the price charged or incurred in a comparable uncontrolled transaction (Regulation 1.482-4(c)(1)). Although the CUT method is not given formal priority under the best-method rule, the regulations note that it will generally provide the most direct and reliable arm's-length price—if the comparable intangible asset is (1) the same as the subject intangible asset and (2) transferred under sufficiently similar circumstances. The CUT method may produce a single result that is the most reliable arm's-length price or a range of acceptable arm's-length prices.
The general standards of comparability govern the selection of a CUT. However, the regulations note that two comparability factors are particularly relevant to the use of the CUT method. First, the proposed comparable intangible asset should be the same as or comparable to the subject intangible asset. Second, comparability will depend on (1) the contractual terms of the transfer and (2) the economic conditions under which the transfer takes place (Regulation 1.482-4(c)(2)(iii)(A)).
The first factor concerns the nature and profitability of the transferred intangible asset. The standard is satisfied if (1) the intangible assets are used in connection with similar products or processes within the same general industry or market and (2) they have similar profit potential. The second factor—whether an uncontrolled transfer is made under "comparable circumstances"—is determined by considering a range of relevant factors.
2. Comparable Profits Method. The CPM determines the arm's-length price for a related party transfer of intangible assets by reference to objective measures of profitability (the PLI) derived from the financial data of unrelated parties. The unrelated parties should be engaged in similar business activities with other unrelated parties under comparable circumstances. Because the CPM determines arm's-length income by reference to an approved measure of operating profit, it relies on a broader scope of data (beyond a specific uncontrolled transaction) to test a related-party transfer. Under the CPM, an appropriate PLI is (1) derived from the financial data of an uncontrolled comparable company and then (2) applied to the financial data of one of the related parties (the "tested party") (Regulation 1.482-5(b)(1)).
The tested party is typically the entity in the related party transaction for which (1) operating profit can be most readily verified with the least and most reliable adjustments and (2) reliable comparable companies can be identified. This aspect of the CPM strives for practicality as well as for comparability. The tested party is typically the least complex related party The ownership of intangible assets is important in determining the tested party. Generally, the least-complex related party will not own valuable intangible assets that could distinguish it from the potential comparable companies (Regulation 1.482-5(b)(2)).
3. Profit-split Method. The profit-split method tests the arm's-length nature of the allocation of combined operating profit (or loss) attributable to the related-party transactions. The profit-split method focuses on the relative value of each related-party contribution to that profit (or loss). This method requires an examination of the most narrowly identifiable business activity of the taxpayer (1) for which data are available and (2) which includes the subject-related-party transactions.
The profit-split method measures the value of each related party's contribution to profit by assessing the (1) functions performed, (2) risks assumed and (3) resources employed by each party (Regulation 1.482-6(b)). This comparison attempts to achieve the same allocation of profit that would have occurred between unrelated parties engaged in the same business segment as the related parties. The profit allocated is not necessarily capped at the total taxpayer profit from that activity. Therefore, one related party may be allocated profit, while the other related party may be allocated loss.
The profit-split method has long been used as a means of resolving related-party-pricing disputes, especially in cases involving the transfer of intangible assets. The current regulations expressly recognize two specific types of profit splits: (1) the comparable profit split and (2) the residual profit split. However, other types of profit splits may qualify as an unspecified method.
The comparable profit-split method looks beyond the allocation of profit made by the controlled taxpayer. This method allocates operating profit based on the comparable allocation of operating profits of unrelated taxpayers with (1) functions, (2) transactions, (3) markets, (4) risks and (5) assets employed (especially intangible assets) similar to those of the controlled taxpayer (Regulation 1.482-6(c)(2)). Therefore, the percentage of combined operating profit earned by the uncontrolled taxpayer acting at arm's-length is used to allocate to each related party the operating profit (or loss) arising from the related party transaction (Regulation 1.482-6(c)(2)(i).
Because the comparable profit-split method is based on a comparison of operating profit, the comparable profit should closely reflect the similarity of the related party and unrelated-party transactions in terms of the (1) resources employed (including both tangible and intangible assets), (2) risks assumed and (3) functions performed by the related parties (Regulation 1.482-6(c)(2)(ii)).
The residual profit split method is of particular significance to related-party transactions that generate above-market profits as a result of the exploitation of intangible assets. The residual profit-split involves a two-step allocation process. First, operating profit (or loss) is allocated to each related party in order to provide that party with a market return for its "routine" contributions to the business activity. The "routine" contributions are similar to those contributions made by unrelated taxpayers in comparable business activities, including the contributions of tangible property, services and intangible assets that are typically owned by unrelated taxpayers. The market return is determined by reference to the returns achieved by unrelated taxpayers engaged in similar activities.
Second, once the market-return component for routine contributions is determined, any residual operating profit (or loss) is allocated to the controlled taxpayer based on the relative value of its contribution of nonroutine intangible assets. The residual-income component reflects the profit attributable to the ownership and exploitation of nonroutine intangible assets. Preferably, the value of the intangible-asset contribution will be determined by reference to external market benchmarks reflecting the fair market value of the intangible assets. Such external market benchmarks of intangible asset value, however, are difficult to find. Indeed, if they could be found, the taxpayer may be able to use the CUT or the CPM. Therefore, the regulations acknowledge that the residual profit split may be determined by reference to internal cost allocations.
4. Unspecified Methods. The current §482 regulations permit the use of methods not specifically listed—so-called unspecified methods—to evaluate related party transactions, including transactions involving intangible assets (Regulation 1.482-4(d)). An unspecified method may be similar to one of the specified methods, but with alterations that make it noncompliant with the express requirements of the specified method. In any event, an unspecified method cannot prevail unless it would be considered the best method in the specific circumstances.
Recent IRS Proposed Regulations for Intercompany Services
On Sept. 5, 2003, the Internal Revenue Service (IRS) proposed regulations updating the intercompany transfer pricing rules for transactions involving intercompany services. The proposed regulations (1) suggest certain changes regarding the recognition of income attributable to transferred intangible assets and (2) provide guidance to better coordinate the rules for intercompany services transactions with the rules for intercompany intangible asset transactions.
While regulations for tangible/intangible asset related-party transactions were finalized in the mid-1990s, the regulations for related party services transactions went largely unchanged since 1968. The current regulations require that the intercompany price for controlled transactions involving related party services be consistent with the arm's-length price. The arm's-length price depends on whether the related party services transaction involves "duplicative," "beneficial" or "integral" services.
The regulations state that the arm's-length price for non-integral related-party services is equal to the "costs or deductions" incurred with respect to the services. This is true unless the subject taxpayer establishes that another price is more appropriate. Effectively, this means that the arm's-length price for beneficial services can be equal to (1) cost or (2) cost plus an arm's-length markup. The regulations provide general guidance on (1) the definition of cost and (2) the appropriate allocation of indirect costs.
The arm's-length price for integral related-party services "shall not be deemed equal to cost" but rather "the amount which was charged or would have been charged for the same or similar services in independent transactions with or between unrelated parties under similar circumstances considering all relevant facts." Effectively, this means that integral related-party services should be charged at a price that includes a profit markup.
The proposed regulations will overhaul the way taxpayers document that their related party-services transactions are at arm's-length. Two fundamental issues addressed by the proposed regulations are (1) the definition of a controlled intercompany services transaction and (2) the allowable methods for analyzing related-party services transactions.
A controlled-services transaction is defined as any activity by one controlled taxpayer that results in a "benefit" to one or more other controlled taxpayers. Benefit is defined as a direct, reasonably identifiable increment of economic or commercial value that enhances the recipient's commercial position. Further, an activity is considered to confer a benefit if an uncontrolled taxpayer in comparable circumstances (1) would be willing to pay an unrelated party to perform that activity or (2) would be willing to perform that activity for itself.
The proposed regulations also clarify those controlled services that (1) do not confer a benefit, and therefore (2) do not merit an arm's-length price. Consistent with the current regulations, the proposed regulations retain the concepts of (1) duplicative activities and (2) activities that produce only indirect or remote benefits. Both types of activities are not considered to provide a benefit to the recipient (unless the activities yield an identifiable, additional benefit). The proposed regulations describe other activities that do not confer a benefit, including (1) shareholder activities (excluding day-to-day management) and (2) activities in which a member of the controlled group obtains a benefit solely due to its status as a member of that group.
Once an activity is determined to confer a benefit, it should carry an arm's-length price. The proposed regulations describe six allowable methods for analyzing the arm's-length nature of related-party transactions involving beneficial services.
Three of the six allowable methods—(1) the comparable uncontrolled services-price method (CUSP), (2) the gross services-margin method (GSM) and (3) the cost of services-plus method (CSP)—are direct analogs of the methods allowed for the transfer price of tangible assets (tailored to transactions involving services). Two of the six allowable methods—(1) the comparable-profits method (CPM) and (2) the profit-split methods (PSM)—already exist as specified methods for transferred tangible and intangible assets, respectively, and are applicable to transferred services. The proposed regulations also outline a new allowable method, the simplified cost-based method (SCBM).
The SCBM is of particular interest because this method departs substantially from traditional intercompany transfer pricing methods. The SCBM is designed for low-margin services, such as back-office services. Also, the SCBM is intended to replace the current treatment of non-integral services. Transactions should meet certain conditions and requirements in order to qualify for the SCBM. However, once the qualifying criteria are met, the SCBM is considered to be the best method.
Parties to a bankruptcy may be concerned about intercompany transfer pricing when one related entity is included in the bankruptcy estate and the other is not.
A company should meet two conditions in order to use the SCBM: (1) the company should maintain adequate books and records detailing the determination and allocation of the total cost base, and (2) subject to a de minimus exception, the company should have a written contract in place that outlines (1) the compensation for the transferred services and (2) the allocation of risks between the related parties.
Several types of transactions are not eligible for the SCBM. These ineligible transactions include related-party services:
- similar to those provided to unrelated parties
- provided to a recipient that receives significant amounts of controlled services
- that involve the use of valuable or unique intangible assets and
- that are combined with other types of controlled transactions involving tangible or intangible assets.
The functional analysis provides the factual foundation for establishing a transfer-price method consistent with the arm's-length standard. A controlled transaction meets the arm's-length standard if the results of the transaction are consistent with the results that would have been realized had the same transaction taken place between unrelated entities.
A functional analysis is a procedure for finding and organizing facts about a business in terms of its (1) functions, (2) risks and (3) intangible assets. The functional analysis identifies how these characteristics are divided between (1) the subject-related entities and (2) the subject-related party transactions. The functional analysis describes the value-added activities undertaken by a taxpayer in order to identify comparable transactions that establish an arm's-length price range. A functional analysis is important to the development of an arm's-length transfer price for the following reasons:
- The functions undertaken by each related party typically correlate with (a) the risks borne and (b) the intangible assets assumed or developed.
- The functions, risks and intangible assets associated with a related party's operations usually have a significant effect on its profitability.
- The functional analysis provides the information necessary to (a) characterize intercompany transactions and (b) identify uncontrolled transactions comparable to the related-party transactions.
The functional analysis begins with a business overview. This overview has two primary purposes. The first purpose is to furnish a general understanding of the subject company by providing information on such topics as its history, products, customers and strategic direction. The second purpose is to describe the industry in which the company operates. This industry review should provide an understanding of the critical success factors in the industry, the client's competitors and the industry's major trends.
Following the business overview, the functional analysis investigates the functions assumed by the related parties in the specific related transactions. For this analysis, the functions are simply the activities that each entity to a particular transaction performs as a normal part of its operations. Functions are generally divided into the following three categories:
- Product and manufacturing functions, or those activities that impact the research, development and manufacturing of a company's products.
- Marketing, advertising and sales and distribution functions, or those activities that impact the manner in which the company's products are marketed, advertised, sold and distributed.
- General management functions, or those activities such as treasury management, development of information systems, etc. that are necessary to support the operations of the company.
The discussion of intangible assets is typically followed by a summary of the key business risks encountered by the related parties to the subject transaction. Business risks exist due to the possibility of events arising to the detriment of the business. A significant portion of the return earned by any company reflects the fact that the business is bearing risks of various kinds.
The functional analysis concludes with a characterization of each of the related entities in the context of the subject transaction(s) covered in the functional analysis. This functional analysis is repeated for each transaction covered in the intercompany transfer price study.
Summary and Conclusion
Parties to a bankruptcy may be concerned about intercompany transfer pricing when one related entity is included in the bankruptcy estate and the other is not. The IRS is also faced with the problem of allocating taxable income related to the intercompany transfer of assets/services in the case of multinational corporations. Accordingly, over the years, the U.S. Treasury promulgated detailed regulations for the determination of transfer prices for the arm's-length intercompany use of transferred assets/services. The economic-analysis methods allowed under these regulations allocate the total income of the multinational taxpayer based on the use of assets/services transferred between domestic and foreign taxing jurisdictions.
These assets/services transfer-price methods have been developed/updated over decades and tested/interpreted in the federal courts. These transfer price methods could be used to fairly allocate income between commonly controlled, related parties when one entity is included in the bankruptcy estate and the other entity isn't. Consistent with the conceptual framework of §482, the total income would be allocated as if the assets/services were owned/provided by independent, arm's-length entities.